Chapter 5

The Mathematics of Diversification

1

12

21
31

( ij )

N1

For i, j 1,....., N

...

13
23

32

...

...

N2

N3

...

1N
2 N
3 N

Introduction

The reason for portfolio theory

mathematics:
To show why diversification is a good idea
To show why diversification makes sense
logically

Introduction (contd)

Harry Markowitzs efficient portfolios:

Those portfolios providing the maximum return
for their level of risk
Those portfolios providing the minimum risk
for a certain level of return

Introduction

A portfolios performance is the result of

the performance of its components
The return realized on a portfolio is a linear
combination of the returns on the individual
investments
The variance of the portfolio is not a linear
combination of component variances
4

Return

The expected return of a portfolio is a

weighted average of the expected returns of
the components:
n

E ( R%
)

x
E
(
R
i i )
p
i 1

where xi proportion of portfolio

invested in security i and
n

x
i 1

1
5

Variance
Introduction
Two-security case
Minimum variance portfolio
Correlation and risk reduction
The n-security case

Introduction

Understanding portfolio variance is the

essence of understanding the mathematics
of diversification
The variance of a linear combination of random
variables is not a weighted average of the
component variances

Introduction (contd)

For an n-security portfolio, the portfolio

variance is:
n

xi x j ij i j
2
p

i 1 j 1

where xi proportion of total investment in Security i

ij correlation coefficient between

Security i and Security j
8

Two-Security Case

For a two-security portfolio containing

Stock A and Stock B, the variance is:

2p x A2 A2 xB2 B2 2 xA xB AB A B

Two Security Case (contd)

Example
Assume the following statistics for Stock A and Stock B:
Expected return
Variance
Standard deviation
Weight
Correlation coefficient

Stock A

Stock B

.015
.050
.224
40%

.020
.060
.245
60%
.50

10

Two Security Case (contd)

Example (contd)
Solution: The expected return of this two-security
portfolio is:
n

E ( R%
p ) xi E ( Ri )
i 1

A ) xB E ( R%
B )
x A E ( R%
0.4(0.015) 0.6(0.020)
0.018 1.80%

11

Two Security Case (contd)

Example (contd)
Solution (contd): The variance of this two-security
portfolio is:

2p x A2 A2 xB2 B2 2 xA xB AB A B
(.4) (.05) (.6) (.06) 2(.4)(.6)(.5)(.224)(.245)
.0080 .0216 .0132
.0428
2

12

Minimum Variance Portfolio

The minimum variance portfolio is the

particular combination of securities that will
result in the least possible variance

Solving for the minimum variance portfolio

requires basic calculus

13

Minimum Variance
Portfolio (contd)

For a two-security minimum variance

portfolio, the proportions invested in stocks
A and B are:

A B AB
xA 2
2
A B 2 A B AB
2
B

xB 1 x A
14

Minimum Variance
Portfolio (contd)
Example (contd)
Solution: The weights of the minimum variance portfolios
in the previous case are:

B2 A B AB
.06 (.224)(.245)(.5)
xA 2

59.07%
2
A B 2 A B AB .05 .06 2(.224)(.245)(.5)
xB 1 x A 1 .5907 40.93%
15

Minimum Variance
Portfolio (contd)
Example (contd)
1.2

Weight A

1
0.8
0.6
0.4
0.2
0
0

0.01

0.02

0.03

0.04

Portfolio Variance

0.05

0.06
16

Correlation and
Risk Reduction
Portfolio risk decreases as the correlation
coefficient in the returns of two securities
decreases
Risk reduction is greatest when the
securities are perfectly negatively correlated
If the securities are perfectly positively
correlated, there is no risk reduction

17

The n-Security Case

For an n-security portfolio, the variance is:

n

xi x j ij i j
2
p

i 1 j 1

where xi proportion of total investment in Security i

ij correlation coefficient between

Security i and Security j

18

The n-Security Case (contd)

A covariance matrix is a tabular

presentation of the pairwise combinations
of all portfolio components
The required number of covariances to compute
a portfolio variance is (n2 n)/2
Any portfolio construction technique using the
full covariance matrix is called a Markowitz
model
19

Example of Variance-Covariance
Matrix Computation in Excel

20

21

22

Portfolio Mathematics (Matrix Form)

Define w as the (vertical) vector of weights on the

different assets.
Define the (vertical) vector of expected returns
Let V be their variance-covariance matrix
The variance of the portfolio is thus:

p2 w 'Vw

Portfolio optimization consists of minimizing this

variance subject to the constraint of achieving a
given expected return.
23

Portfolio Variance in the 2-asset case

We have:
wA
w
wB

and

A2
AB

AB

B2

Hence:
2

AB wA
2
A
p w 'Vw wA wB
w
2
AB B B
p2 wA2 A2 wB2 B2 2wA wB AB

p2 wA2 A2 wB2 B2 2wA wB AB A B

24

Covariance Between Two Portfolios

(Matrix Form)

Define w1 as the (vertical) vector of weights on the

different assets in portfolio P1.
Define w2 as the (vertical) vector of weights on the
different assets in portfolio P2.

Define the (vertical) vector of expected returns

Let V be their variance-covariance matrix
The covariance between the two portfolios is:

P1 , P2 w1 'Vw2 w2 'Vw1

(by symmetry)
25

The Optimization Problem

Minimize w 'Vw
w

Subject to:

1' w 1

' w E ( R p )

where E(Rp) is the desired (target) expected return on the

portfolio and is a vector of ones and the vector is

defined as:

1
M
n

E ( R 1 )

E ( R n )

26

Lagrangian Method
1
Min L w 'Vw E ( R p ) w ' 1 w '

2
w

Or: Min L w 'Vw E ( R p ) w ' , 1 w '

2
w

Thus: Min L 1 w 'Vw E ( R p ),1 w ' ,

2
w

where the notation ,

1

indicates the matrix 2
M

1
1

27

Taking Derivatives

1
0 w V ,

(1)

E ( R ),1 w ' ,1 0, 0

(2)

L
Vw ,

L

0
0
L

Plugging (1) into (2) yields:

' 1
E ( Rp ),1 , V ,

1'

1 0, 0
28

And so we have:
' 1

, E ( Rp ),1 V ,

In other words:

1'

1 ' 1

E ( R p )
V
1
Plugging the last expression back into (1) finally yields:
1

1 1 '

1
w

{
{
{
( n1)
( n n ) {
1 2 3 ( n n ) {
n2)
( n2)
(2n )
1 4
1 4 2 (43
4 4 2 4 4 43
( n2)
1 4 4 4 4 4 4 44(222)4 4 4 4 4
1

( n1)

E ( R p )
1
14 2 43
(21)

4 4 43
29

The last equation solves the mean-variance

portfolio problem. The equation gives us
the optimal weights achieving the lowest
portfolio variance given a desired expected
portfolio return.
Finally, plugging the optimal portfolio
2

weights back into the variance p w 'Vw

gives us the efficient portfolio frontier:

1 'V 1

E ( R p ),1 ,

2
p

E ( R p )

30

Global Minimum Variance Portfolio

In a similar fashion, we can solve for the global

minimum variance portfolio:
*

1'
V

1'V 1
1

2
*

1'V 1
1

with w*

1'V 1
V 1

The global minimum variance portfolio is the

efficient frontier portfolio that displays the
absolute minimum variance.
31

Another Way to Derive the MeanVariance Efficient Portfolio Frontier

Make use of the following property: if two

portfolios lie on the efficient frontier, any
linear combination of these portfolios will
also lie on the frontier. Therefore, just find
two mean-variance efficient portfolios, and
compute/plot the mean and standard
deviation of various linear combinations of
these portfolios.
32

33

34

Some Excel Tips

To give a name to an array (i.e., to name a

matrix or a vector):
Highlight the array (the numbers defining the
matrix)
Click on Insert, then Name, and finally
Define and type in the desired name.

35

Excel Tips (Contd)

To compute the inverse of a matrix

previously named (as an example) V:
Type the following formula: =minverse(V)
and click ENTER.
Re-select the cell where you just entered the
formula, and highlight a larger area/array of the
size that you predict the inverse matrix will
take.
Press F2, then CTRL + SHIFT + ENTER
36

Excel Tips (end)

To multiply two matrices named V and

W:
Type the following formula: =mmult(V,W)
and click ENTER.
Re-select the cell where you just entered the
formula, and highlight a larger area/array of the
size that you predict the product matrix will
take.
Press F2, then CTRL + SHIFT + ENTER
37

Single-Index Model
Computational Advantages

The single-index model compares all

securities to a single benchmark
An alternative to comparing a security to each
of the others
By observing how two independent securities
behave relative to a third value, we learn
something about how the securities are likely to
behave relative to each other
38

Computational
Advantages (contd)

A single index drastically reduces the

number of computations needed to
determine portfolio variance
A securitys beta is an example:
%
COV ( R%
i , Rm )
i
m2
where R% return on the market index
m

m2 variance of the market returns

R%
i return on Security i
39

Portfolio Statistics With the

Single-Index Model

Beta of a portfolio:
n

p xi i
i 1

Variance of a portfolio:
2p p2 m2 ep2
p2 m2
40

Proof

Ri R f i ( Rm R f ) ei
n

R p xi Ri R f xi i ( Rm R f ) xi ei
i 1
i 1
i 1
1
4 2 43
1
23
p

ep

R p R f xi i Rm xi i R f xi ei
i 1
1
4 2 43
1i412 43
1i 12 3
p

xi i

i 1
1
4 2 43

p2

ep

m2 xi2 ie2 p2 m2 ep2 p2 m2

i 1

41

Portfolio Statistics With the

Single-Index Model (contd)

Variance of a portfolio component:

2
i

2
i

2
m

2
ei

Covariance of two portfolio components:

AB A B m2
42

Proof
Ri R f i Rm i R f ei

i2 i2 m2 ei2
A, B Cov( RA , RB ) Cov( R f A Rm A R f eA , R f B Rm B R f eB )
A, B Cov( A Rm eA , B Rm eB )
A, B Cov( A Rm , B Rm ) Cov(eA , B Rm ) Cov( A Rm , eB ) Cov(eA , eB )
A, B A B Cov( Rm , Rm ) A B m2
43

Multi-Index Model

A multi-index model considers independent

variables other than the performance of an
overall market index
Of particular interest are industry effects
Factors associated with a particular line of business
E.g., the performance of grocery stores vs. steel
companies in a recession
44

Multi-Index Model (contd)

The general form of a multi-index model:

%
%
%
%
R%
i ai im I m i1 I1 i 2 I 2 ... in I n
where ai constant
I% return on the market index
m

I%
j return on an industry index

ij Security i's beta for industry index j

im Security i's market beta
R%
i return on Security i

45